Dividend Policy

Why this matters

Dividends and Buybacks explained how a dividend reaches you. This lesson is about the decision behind it. A board that sets a dividend is saying something about what it expects the business to earn for years, and a board that cuts one is saying something too. Knowing how those decisions are made lets you read them, and tells you which dividends are likely to last.

In theory, it doesn't matter

Franco Modigliani and Merton Miller, whose result on debt and equity appeared in Capital Structure, showed something similar for dividends. Under the same idealized assumptions, a company's dividend policy doesn't affect its market value.¹ The reasoning is that a dividend doesn't create anything. It moves cash from the company's account to the shareholder's, and the shares are worth that much less afterward. A shareholder who wants cash and doesn't get a dividend can sell a few shares instead.

You own 100 shares at $50, worth $5,000, and want $200 of cash.

	Company pays a $2 dividend	No dividend, and you sell 4 shares
Cash received	100 × $2 = $200	4 × $50 = $200
Shares held afterward	100 at $48	96 at $50
Value of shares	$4,800	$4,800
Total	$5,000	$5,000

Either way you have $200 in cash and $4,800 in shares. In the first column the share price falls by the dividend, because the company has $2 less per share. In the second, the company kept the cash and you hold a slightly smaller part of a slightly larger company.

The main message of the theory is that if dividend policy does affect a company's value, the cause is taxes or some other identifiable departure from the idealized model.¹ So the useful question is which departures matter.

Why it matters in practice

• Taxes. In a taxable account, a dividend is generally taxed in the year it's received.² A shareholder who isn't paid a dividend and doesn't sell owes nothing yet.³ The dividend takes away the choice of when to pay.
• Discipline. Cash that has left the company can't be spent on a poor acquisition or a project that earns less than its cost. The last lesson showed how much that can be worth. A regular dividend forces management to live on what remains.
• Commitment. Managers treat a regular dividend as close to a promise, which the next section describes. That makes it a signal.
• What shareholders want. Some investors live on the income and prefer not to sell shares to get it. In a survey of 384 finance chiefs and treasurers published in 2003, executives said they believed individual investors have a strong preference for dividends, despite the tax disadvantage.⁴

The rest of this lesson is for members

Still to come in this lesson: How companies set the dividend, Is the dividend safe?, Reading the changes, the key takeaways, and 2 quiz questions with explanations.

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